Porter's Value Chain

Understanding How Value is Created Within

Organizations
By the Mind Tools Content Team

How does your organization create value?

How do you change business inputs into business outputs in such a way that
they have a greater value than the original cost of creating those outputs?

This isn't just a dry question: it's a matter of fundamental importance to

companies, because it addresses the economic logic of why the organization
exists in the first place.

Manufacturing companies create value by acquiring raw materials and using

them to produce something useful. Retailers bring together a range of products
and present them in a way that's convenient to customers, sometimes
supported by services such as fitting rooms or personal shopper advice. And
insurance companies offer policies to customers that are underwritten by
larger re-insurance policies. Here, they're packaging these larger policies in a
customer-friendly way, and distributing them to a mass audience.

The value that's created and captured by a company is the profit margin:

Value Created and Captured – Cost of Creating that Value = Margin

The more value an organization creates, the more profitable it is likely to be.
And when you provide more value to your customers, you build competitive
advantage.
Understanding how your company creates value, and looking for ways to add
more value, are critical elements in developing a competitive strategy. Michael
Porter discussed this in his influential 1985 book "Competitive Advantage

," in which he first introduced the concept of the value chain.

A value chain is a set of activities that an organization carries out to create

value for its customers. Porter proposed a general-purpose value chain that
companies can use to examine all of their activities, and see how they're
connected. The way in which value chain activities are performed determines
costs and affects profits, so this tool can help you understand the sources of
value for your organization.

Elements in Porter's Value Chain

Rather than looking at departments or accounting cost types, Porter's Value

Chain focuses on systems, and how inputs are changed into the outputs
purchased by consumers. Using this viewpoint, Porter described a chain of
activities common to all businesses, and he divided them into primary and
support activities, as shown below.
A well-maintained chain helps your business to run more smoothly.
Matc13 / © iStockphoto

Primary Activities
Primary activities relate directly to the physical creation, sale, maintenance
and support of a product or service. They consist of the following:

 Inbound logistics. These are all the processes related to receiving,

storing, and distributing inputs internally. Your supplier relationships
are a key factor in creating value here.
 Operations. These are the transformation activities that change inputs
into outputs that are sold to customers. Here, your operational systems
create value.
 Outbound logistics. These activities deliver your product or service to
your customer. These are things like collection, storage, and distribution
systems, and they may be internal or external to your organization.
 Marketing and sales. These are the processes you use to persuade
clients to purchase from you instead of your competitors. The benefits
you offer, and how well you communicate them, are sources of value
here.
 Service. These are the activities related to maintaining the value of your
product or service to your customers, once it's been purchased.

Support Activities

These activities support the primary functions above. In our diagram, the
dotted lines show that each support, or secondary, activity can play a role in
each primary activity. For example, procurement supports operations with
certain activities, but it also supports marketing and sales with other activities.

 Procurement (purchasing). This is what the organization does to get

the resources it needs to operate. This includes finding vendors and
negotiating the best prices.
  Human resource management. This is how well a company recruits,
hires, trains, motivates, rewards, and retains its workers. People are a
significant source of value, so businesses can create a clear advantage
with good HR practices.
 Technological development. These activities relate to managing and
processing information, as well as protecting a company's knowledge
base. Minimizing information technology costs, staying current with
technological advances, and maintaining technical excellence are
sources of value creation.
 Infrastructure. These are a company's support systems, and the
functions that allow it to maintain daily operations. Accounting, legal,
administrative, and general management are examples of necessary
infrastructure that businesses can use to their advantage.

Companies use these primary and support activities as "building blocks" to

create a valuable product or service.

Using Porter's Value Chain

To identify and understand your company's value chain, follow these steps.

Step 1 – Identify subactivities for each primary activity

For each primary activity, determine which specific subactivities create value.
There are three different types of subactivities:

 Direct activities create value by themselves. For example, in a book

publisher's marketing and sales activity, direct subactivities include
making sales calls to bookstores, advertising, and selling online.
  Indirect activities allow direct activities to run smoothly. For the book
publisher's sales and marketing activity, indirect subactivities include
managing the sales force and keeping customer records.
 Quality assurance activities ensure that direct and indirect activities
meet the necessary standards. For the book publisher's sales and
marketing activity, this might include proofreading and editing
advertisements.

Step 2 – Identify subactivities for each support activity.

For each of the Human Resource Management, Technology Development and

Procurement support activities, determine the subactivities that create value
within each primary activity. For example, consider how human resource
management adds value to inbound logistics, operations, outbound logistics,
and so on. As in Step 1, look for direct, indirect, and quality assurance
subactivities.

Then identify the various value-creating subactivities in your company's

infrastructure. These will generally be cross-functional in nature, rather than
specific to each primary activity. Again, look for direct, indirect, and quality
assurance activities.

Step 3 – Identify links

Find the connections between all of the value activities you've identified. This
will take time, but the links are key to increasing competitive advantage from
the value chain framework. For example, there's a link between developing the
sales force (an HR investment) and sales volumes. There's another link
between order turnaround times, and service phone calls from frustrated
customers waiting for deliveries.

Step 4 – Look for opportunities to increase value

Review each of the subactivities and links that you've identified, and think
about how you can change or enhance it to maximize the value you offer to
customers (customers of support activities can be internal as well as external).

Tip 1:

Your organization's value chain should reflect its overall generic business
strategies

. So, when deciding how to improve your value chain, be clear about whether
you're trying to set yourself apart from your competitors or simply have a
lower cost base.

Tip 2:

You'll inevitably end up with a huge list of changes. See our article on
prioritization

if you're struggling to choose the most important changes to make.

Tip 3:

This looks at the idea of a value chain from a broad, organizational viewpoint.
Our separate article on value chain analysis

takes a different look at this topic, and uses an approach that is also useful at a team or
individual level. Click here

to explore this.
Key Points

Porter's Value Chain is a useful strategic management tool.

It works by breaking an organization's activities down into strategically

relevant pieces, so that you can see a fuller picture of the cost drivers and
sources of differentiation, and then make changes appropriately.